It has been more than a decade since the last U.S. recession. Prior to that, the longest gap between recessions was exactly a decade. Moreover, when I started drafting this post and its related video, the U.S. yield curve had briefly inverted, which means longer-term bond rates were lower than shorter-term bond rates. Besides this being a bit Alice-in-Wonderland-like, inverted yield curves also have been good predictors of coming U.S. recessions.

I do not know whether this supposed predictive power will hold true again this time. But for the sake of argument, let’s assume it will. On average, globally diversified Canadian investors have had negative stock returns during past U.S. recessions. For example, if we look at the last six U.S. recessions, we can see that a Canadian invested in a Canadian/U.S./international index fund portfolio lost money during these downturns in most, but not all cases[1].

No wonder we get nervous when recession signs start flashing. Nobody wants to lose money, so it makes sense to wonder whether you can avoid doing so in a next recession.

Unfortunately, feeling nervous about potential losses does not make it any easier to successfully avoid them. Getting out of the stock market at the right time to avoid negative returns – and getting back in when it’s “over” – is much easier said than done.

Predicting Recessions vs. Predicting Market Performance

Back to that inverted yield curve. Since 1966, there have been eight U.S. yield curve inversions and seven U.S. recessions. Six of those recessions occurred within six quarters after the inversion. There was only one false positive in 1966, when an inversion was not followed by a recession within six quarters.

Again, let’s say an inverted yield curve is a useful economic indicator. The challenge is, even if it were perfect at predicting a coming recession, it would not necessarily be as useful at predicting future stock returns. 

Eugene Fama and Kenneth French addressed this paradox in a July 2019 paper, Inverted Yield Curves and Expected Stock Returns. They acknowledge there is strong empirical evidence, some of it from Fama’s own work, suggesting that, (1) the slope of the yield curve predicts economic activity, and (2) inverted yield curves tend to forecast future recessions.

To relate this to stock returns, Fama and French built a market-timing model that moved a portfolio out of equites and into treasury bills when the local yield curve was inverted. They then ran the model on three different U.S. investor portfolios: the U.S. market, the world ex-U.S. market, and the world market.

The big question: Could they add value to these portfolios with an actively managed strategy that shifted holdings out of equities and into treasuries based on yield curve inversions? In other words, if an inverted yield curve is an imperfect, but historically strong predictor of a coming recession, could they use the indicator to time the market, or at least protect a portfolio with a few defensive trades?

Based on their analysis, Fama and French conclude:

“The results should disappoint investors hoping to use inverted yield curves to improve their expected portfolio return … We find no evidence that yield curve inversions can help investors avoid poor stock returns.”

They explain further:

“The simplest interpretation of the negative active premiums we observe is that yield curves do not forecast the equity premium. This interpretation implies that investors who try to increase their expected return by shifting from stock to bills after inversions just sacrifice the reliably positive unconditional expected equity premium.”

Market-Timing Is Never in Season

Stated another way, you should not depend on the yield curve to inform your investment decisions; trying to shift your portfolio into safer assets ahead of a possible recession is more likely to hurt than help your end returns.

There are two main reasons I remain opposed to market-timing in advance of a recession, whether in response to an inverted yield curve or any other supposed indicator:

1. We still cannot predict precisely when the next recession will happen.

2. Even if we could, we cannot predict how stock markets will react to it.

There is strong and considerable evidence that we can manage a portfolio to capture the market’s expected long-term returns. There is far less evidence we can successfully move to safe harbour to avoid the rough patches … even if we believe they’re imminent. So why pursue the latter (market-timing) by sacrificing some of former (common sense investing)? Simply put, it does not make sense. 

The Protective Power of Factor-Based Diversification

This does not mean we are powerless to prepare our portfolios for recessions. The best way to prepare for any economic outcome, including a bad one, remains the same as ever: Build a properly diversified portfolio – diversified across geographies, asset classes, and risk factors – and stick with it over time.

But what does that portfolio look like? In a 2017 paper, Fama-French Factors and Business Cycles, authors Arnav Sheth and Tee Lim offered us some insights by examining the performance of the market, size, value, momentum, investment, and profitability factors across business cycles. (Remember, owning a market-cap weighted index fund only gives you exposure to the market factor. To gain exposure to the others, you would need to overweight them relative to the market. For example, exposure to the value factor would require adding additional exposure to value stocks, beyond their market-cap weight.)

First, Sheth and Lim broke the business cycle into four stages: Recession, Early Stage (recovery), Late Stage (recovery), and Very Late Stage (recovery). Then they looked at these cycles across 10 U.S. recessions designated by the National Bureau of Economic Research going back to 1953. They examined the following:

• How each factor performed during each stage

• How each performed following yield curve inversions

• Cumulative factor returns for the 10 months following each recession (the median length of historical U.S. recessions)

On average, the best-performing factors during a recession were:

• The investment factor, with an average cumulative 10-month premium of 18.3% during recessions

• The value factor, with an average cumulative 10-month premium of 12.5% during recessions

In the Early and Late stages of the economic cycle, the investment premium tapered off, while the value premium remained strong into the Very Late stage before tapering off.

Possibly the most interesting insight from the paper is that the value premium has historically been at its lowest in the Very Late stage of an economic cycle.

The reason this is interesting is that, as of August 2019, U.S. value stocks have been underperforming U.S. growth stocks for over a decade in terms of annualized returns. If we look back in time, the decade ending on March 31, 2000 looked very similar to today: Value stocks had been trailing growth stocks for more than a decade in terms of average annualized returns.

Then the 2001 U.S. recession hit. Its debilitating effect on growth stocks was so dramatic, that for the decade ending March 2001, the entire trailing decade showed a positive value premium – simply by moving ahead one year from March 2000. Despite nine years of disappointment, that one year made all the difference for the value premium … at least for those who had stuck with it.

This anecdote is in line with the findings from Sheth and Lim, suggesting that the value premium tends to be weakest late in the economic cycle, and strongest in recessions and early-stage recovery.

This does NOT mean you can successfully time the value factor. Remember, the Sheth and Lim paper observed known recessionary periods with perfect hindsight. Even if we know that value tends to do well in recessions, we still cannot precisely predict the timing of the recessions themselves.

Sheth and Lim’s findings DO inform us that the known risk factors have performed differently at different stages of the economic cycle. This further strengthens our belief that diversifying across risk factors remains an important part of portfolio management. This should come as no surprise. In their 2012 paper, The Death of Diversification Has Been Greatly Exaggerated, Jared Kizer and Antti Ilmanen identified factor diversification as a crucial aspect of diversification. They found that “factor diversification has been more effective than asset-class diversification in general, and, in particular, during crises.”

Second Verse, Same as the First

I must reiterate, none of the preceding discussion should be viewed as an endorsement for market-timing. An allocation to value stocks or any other specific factor is a long-term decision, and it is not always an easy decision to live with. Value’s poor performance over the past decade has not been an easy pill to swallow. As tempting as it may be to try to time your trades into and out of the vale factor, I advise against it. In a 2017 paper, “Contrarian Factor Timing is Deceptively Difficult,” Ilmanen and his colleagues at AQR Capital Management built a value-timing strategy to test this, and found lackluster results. They concluded, “maintaining consistent factor exposure is a tough benchmark to beat.”

I have not told you anything new. Market timing is hard, and diversification is important. It is generally optimal to stay invested in a risk-appropriate portfolio all of the time. Otherwise, as Fama and French put it, you “sacrifice the reliably positive unconditional expected equity premium.” Based on how different risk factors perform through the business cycles, one of the best ways to be prepared for a recession might be overweighting value stocks relative to the market to gain exposure to the value factor … if you have the stomach to stick with your decision through thick and thin.

Through bull markets and bear, don’t forget, if you have run out of Common Sense Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder Podcast wherever you get your podcasts.

[1] Analysis by Ben Felix